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SEC Can Redeem Itself Through a Tougher Citigroup Deal: View

Nov. 9 (Bloomberg) -- There will be plenty of questions
left after today’s hearing on a $285 million fraud settlement
Citigroup Inc. reached last month with the Securities and
Exchange Commission.

But there should be only one answer from Jed S. Rakoff, the
federal judge in New York assigned to weigh the merits of the
agreement: You’ve got to be kidding.

The case involves the creation and sale of one of the more
toxic versions of an investment whose structure almost defies
explanation -- a $1 billion synthetic collateralized debt
obligation that was based on other collateralized securities
that were in turn tied to subprime residential mortgages. The
CDO was put together by Citigroup’s broker-dealer unit in early
2007, just as the housing market started to slump. It wasn’t
meant to make money for the buyers; it was designed to blow up,
the SEC says. Before the year was out, the CDO was in default.
Investors eventually lost almost everything.

For Citigroup, the CDO worked out well. The SEC lawsuit
says the bank bet against the CDO and made a $160 million
profit. The nonprofit organization Better Markets, which has
asked Rakoff to oppose the settlement, estimates Citigroup’s
profit at $600 million to $700 million. As in most SEC deals
with companies in securities-fraud litigation, Citigroup will be
allowed to say it neither admits nor denies wrongdoing. The
agency takes this conciliatory route on the assumption that it
will generally be outlitigated and outlasted by Wall Street
firms.

The settlement wouldn’t be so troubling if Citigroup hadn’t
done this many times before. As Bloomberg View columnist
Jonathan Weil pointed out last week, five times since 2003 the
SEC has accused Citigroup’s broker-dealer arm of securities
fraud. Each time, Citigroup settled the SEC’s accusation without
admitting or denying wrongdoing, paid fines and promised not to
break the law again. There were no consequences for subsequent
violations. At a minimum, the SEC should lay out a schedule of
additional fines for these kinds of repeat offenses.

Rakoff has a record of skepticism toward the SEC’s
sweetheart deals. The most memorable was his rejection in 2009
of Bank of America Corp.’s plan to pay $33 million to settle an
SEC lawsuit. The agency had accused the bank of misleading
investors about its purchase of Merrill Lynch & Co. In the end,
Bank of America paid $150 million.

Based on Rakoff’s questions about the Citigroup settlement
filed last month with the court, he seems to have doubts about
its merits. One point he will consider is whether this deal
serves the public interest by promoting fairness and
transparency in financial markets. Initially, the SEC said the
proposed agreement met the public-interest standard. In a court
filing this week, the agency seemed to say that question was for
the SEC to decide rather than the court.

Some of the investors in the CDO disagree. Union Central
Life Insurance Co. says it opposes the settlement because many
of the facts the SEC excavated in its investigation will be
“swept under the rug without public scrutiny.”

The size of the SEC’s fine -- $160 million in disgorged
profits, $95 million in penalties and $30 million in interest --
verges on anemic. Goldman Sachs Group Inc. paid a $535 million
fine for a similarly constructed CDO. The distinction, the SEC
says, is that Goldman acted with scienter, which in such cases
means knowingly engaging in securities fraud. The SEC says
Citigroup was simply negligent. If so, that doesn’t seem to
square with the case laid out in the lawsuit.

The SEC is a long way from reclaiming its role as a
sensible industry watchdog. Renegotiating the Citigroup
settlement would set it on course to redeem its enforcement bona
fides. Barring that, Rakoff should tell Citigroup and the SEC to
come back to him with an agreement that better reflects the
severity of Citigroup’s actions.